The Financial Crisis of 2007–2009: Why Did It Happen and What Did We Learn?

Abstract

This review of the literature on the 2007–2009 crisis discusses the precrisis conditions, the crisis triggers, the crisis events, the real effects, and the policy responses to the crisis. The precrisis conditions contributed to the housing price bubble and the subsequent price decline that led to a counterparty-risk crisis in which liquidity shrank due to insolvency concerns. The policy responses were influenced both by the initial belief that it was a market-wide liquidity crunch and the subsequent learning that insolvency risk was a major driver. I suggest directions for future research and possible regulatory changes. (JEL G20, G21, E58, G28) In its analysis of the crisis, my testimony before the Financial Crisis Inquiry Commission drew the distinction between triggers and vulnerabilities. The triggers of the crisis were the particular events or factors that touched off the events of 2007–2009—the proximate causes, if you will. Developments in the market for subprime mortgages were a prominent example of a trigger of the crisis. In contrast, the vulnerabilities were the structural, and more fundamental, weaknesses in the financial system and in regulation and supervision that served to propagate and amplify the initial shocks.